There are 2 approaches to systems parameters:
- Decide on a set of parameters for the strategy and stick to it
- Keep changing the system parameters based on the latest market conditions (chameleon approach)
The chameleon method will inherently be lagging and, as a result, might not give you very good results. Think about being stuck in a traffic jam on the highway: you always think the queue next to you is faster – but it seems that every time you change lanes, the one you just left picks up speed… and you end up being stuck even longer!
In terms of automated trading, you might end up with a system that chases its tail (instead of chasing the fat-tail). Of course there are “different shades of grey” and some parts of the system can be self-adapting (volatility-adjusted indicators for example) and allow for a middle ground approach. Consider the Turtle Rules as an example: they used to have static parameters (i.e. 20 and 55 days breakouts) but used ATR as a central part of their strategy to adapt to different volatility levels.
The concept of chasing its tail can also be illustrated by this story about Bill Dunn:
The World Monetary program currently trades 13 markets. Back testing 10 to 12 years (each year has equal weighting), Dunn annually adjusts the parameters of trading signals and each market’s weighting. In February – just as the grains were about to take off – he dumped the entire grain sector.
Performance will depend on how fast the chameleon can adapt and be responsive while keeping a robust approach. We will try to find out…
In a next post, we will cover Walk-Forward testing (which uses a sliding look-back period for back-test and applies the optimal parameters to the latest trading period). It can be associated with a chameleon approach. We will also run a comparison test between the 2 approaches and see how the chameleon performs!